A New Commodities Investment: “S&P GSCI™ Enhanced Commodity Total Return Strategy Index-Linked Note.”

Yes, it’s a mouthful, but we’re very pleased to have brought this enhancement to client portfolios.

During the second quarter we sold substantially all commodities positions across our client accounts to invest in a new exchange traded note, issued by Goldman Sachs. This note offers the return of the S&P GSCI Enhanced Commodity Total Return Strategy Index (the “enhanced commodity note” or “ECN”).

This new note reflects more than a year of Kochis Fitz research and a joint product development effort with Goldman Sachs (the creator of the widely used commodities index: GSCI). We have been eager to understand the weaknesses inherent in the standard commodities indexes and to structure enhancements to avoid or mitigate them. The result is, as far as we know, the first ever exchange traded note to combine a standard market exposure with the kind of systematic trading strategy that hedge funds pursue at much higher cost. Goldman Sachs has registered this investment with the SEC, and their application for listing on the NYSE has been filed. We expect the ECN to garner national media attention in the coming month when the SEC grants Goldman’s request for listing.

What Are The Enhancements?

The ECN offers the same underlying commodities exposure as the S&P GSCI (same commodities, same weights) with the same tax efficiency as the iPath S&P GSCI exchange traded note (ticker GSP) we have until now used to fund this exposure in client portfolios. The enhancement consists of three modifications to the manner in which commodity futures are “rolled” from one contract to another. These enhancements are expected to add tremendous value relative to the index’s standard roll procedure.

Some Background on Roll Yield

The commodities indexes represent the return to owning commodities using futures. As the name suggests, a commodity futures contract is an agreement to purchase a commodity at a specified point in the future. The market price of the contract reflects a number of market dynamics and the expected price of the commodity in the future. As discussed in an article last year when we first introduced commodity investments to client portfolios, there are three potential sources of commodity futures return: the t-bill return (earned on collateral), unexpected changes in the spot price of the commodity, and the roll yield.

Figure 1 Normal backwardation provides positive roll yield

Figure 2 Contango provides negative roll yield

The indexes are constructed such that, as the maturity dates of the underlying futures contracts approach, the contracts are sold and replacement contracts for delivery further into the future are purchased. This process is called “rolling.” If the price of the replacement contract bought is lower than the price of the contract sold, the futures curve is described as “backwardated” and we reap a gain (the roll yield is positive). If the opposite is true (replacement contracts cost more than the nearing maturity contracts are sold for), the curve is said to be in “contango,” and the roll yield is negative. The shape of the futures curve, which is apparent at the time the contracts are rolled, is the critical determinant of futures returns over the long-run.

Enhancement 1: Modified Roll Period
Since an index is designed to replicate the performance of actual investments in the underlying futures contracts, the rolling process incorporated in the index takes place over a number of business days during each month (referred to as a “roll period”). The roll period applicable to the standard S&P GSCI occurs mechanically from the fifth to ninth business day of the month. The Enhanced Index employs a modified roll period that instead occurs from the first to the fifth business day of the month, in order to sell (and buy) in advance of the selling (and buying) driven by the roll period of the standard S&P GSCI. This avoids at least some of the return-reducing impacts those transaction volumes periodically present.

Enhancement 2: Dynamic Rolling Rule for Oil Futures
In order to gain exposure to the longer end of the futures curve when the front end is in contango, the enhanced index changes the standard rolling rules for the WTI crude oil and Brent crude oil contracts included in the S&P GSCI. These new rules are dynamic, and change based on the degree of contango between the nearby futures contracts.

Figure 3 S&P GSCI Enhanced Commodity Total Return Strategy Index (Dynamic Roll)

Enhancement 3: Seasonal Rolling Rules
The shape of a futures curve is related to the supply and demand dynamics of the underlying commodity. This is particularly true for commodities which are expensive to transport and store, such as natural gas. As mentioned above, the standard S&P GSCI employs a mechanical roll procedure that rolls contracts each and every month, sometimes generating a positive roll yield, sometimes negative.

Figure 4 S&P GSCI Enhanced Commodity Total Return Strategy Index (Seasonality)

However, for seasonal commodities (for example, heating oil or corn), the periods of negative roll yield can be anticipated. In order to take advantage of this known seasonality in the supply and demand of six futures contracts, the enhanced index is designed to earn an excess return by only rolling to periods when conditions are favorable (i.e., the curve is in backwardation).

Performance

Had this particular strategy been in place and running live money for the ten year period ending December 2006, the enhanced strategy would have outperformed the GSCI by over 9% per year (annualized return of 16.43% vs. 7.05%) while reducing annualized volatility from 20.9% to 18.9%. It is important to note that these are backtested numbers, and the actual investment may not deliver similar performance. However, we believe that given the systematic nature of the strategy, the new ECN is, by far, the most attractive investment vehicle to fulfill the commodities exposure incorporated in clients’ overall asset allocation and easily justifies the tax liabilities, if any, that we incurred in selling clients’ former positions.

We appreciate the opportunity to work on our clients’ behalf to find (and, if necessary, create) the most attractive investment opportunities around the world.

Karen Blodgett and Jason Thomas